EM currencies, plumbing dollar lows, gain against euro and yen

Traders who bought emerging market currencies at the start of 2014 could still be in profit, as long as they didn't fund their investment with US dollars. Currencies from the Brazilian real to the Indonesian rupiah and Turkish lira are at multi-year or record lows against the resurgent dollar, saddling many investors with losses on their stock and bond portfolios.

A basket of emerging currencies excluding the Russian rouble, tracked by UBS, had fallen 8.6 percent against the dollar year-to-date by December 16.

Against the euro however, the basket had appreciated 0.7 percent

"A lot of the headlines about EM currency weakness come from dollar strength," said Bernd Berg, EM strategist at Societe Generale. "The significant divergence between the dollar and other funding currencies often gets overlooked."

Traders can avoid spending dollars on currency purchases by borrowing or shorting another currency, known as a funding currency. This year, as the euro and yen have weakened, it would have made sense to use them to fund emerging market purchases.

Versus the Japanese yen too - at seven-year lows to the greenback - many emerging currencies have appreciated.

Take Indonesia's rupiah. It is down 3 percent against the dollar, touching 16-year lows recently, but has gained 8.5 percent and 9.6 percent versus the euro and yen respectively.

South Korea's won has risen 9.9 percent against the yen and 8.5 percent to the euro, contrasting with a 4.3 percent year-to-date fall versus the dollar.

Societe Generale's Berg said he would still recommend using the yen to fund long positions on certain EM currencies, noting expansionary Japanese policies that are likely to weaken the yen further next year.

But not everyone is convinced the trade will deliver returns next year because emerging markets remain in relatively poor shape in terms of economic growth, while volatility is on the rise across global markets.

Moreover, funds based in the United States tend to have much higher allocations to emerging markets than their counterparts in Europe or Japan, so most foreign investment in emerging markets is naturally dollar-based.

"What looks like a sexy trade of short yen against EM may not work for much longer," said Manik Narain, a strategist at UBS.

"Think about the context in which it worked this year: zero volatility, strong stocks, and positive EM growth surprises. If you tweak any of those, it may not work again next year."